Why Corporate Governance Today?

I. Introduction

Corporate governance has become a powerful force in American business over the short span of the past two decades. The movement may best be described as the prudent exercise of ownership rights, toward the goal of increased share value.

In both the national and international marketplace, the California Public Employees' Retirement System (CalPERS) is recognized as a standard-bearer for the movement. Indeed, CalPERS is generally credited as a founder of shareholder activism stemming from its heightened proxy voting activity at selected companies in the mid-1980s.^[1]

Several years ago, CalPERS published a paper to explain its investment objectives and fiduciary duties in connection with the corporate governance movement.^[2]  In this paper, CalPERS will revise its objectives, in light of the growing acceptance in attitude by large companies nationwide; the new proxy voting and fiduciary duty guidelines of federal regulators; and, the emerging importance of the international marketplace.

A central thesis, then and now, is that shareholders must act like owners and take an active interest in the performance of their stock portfolio. It has been more than half a century since the founders of fundamental stock analysis, Benjamin Graham and David Dodd, observed:^[3]

"The choice of a common stock is a single act, its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgment in being a shareholder as in becoming one."^[4]

Today, at the close of the century, corporate governance is still an important tool for monitoring performance and enhancing value -- even though the ultimate shape of this tool is in the process of being forged.

Overview of the System

CalPERS is the largest public pension plan in the United States and the third largest in the world. It serves more than 1,050,000 members and beneficiaries. Its diverse membership includes state, local government and school district employees. Organized as an entity of state government, CalPERS has headquarters in the capital city of Sacramento and eight "field offices" statewide.

CalPERS' 13-member Board of Administration represents the interests of public employees, public employers, and the taxpayers, in careful balance.^[5]  Its composition is set in statute, and protected from political influence by the state constitution.^[6]  Six of the Board members are elected by various active or retired employee groups, two serve by virtue of their elected statewide office and five are appointed by the Governor and/or the Legislature.

Overview of the Fund

The CalPERS fund is a trust, administered under the Board's sole authority. Although CalPERS is exempt from the federal oversight of private pension funds, it turns to these standards and the "common law" of trusts for guidance.

The CalPERS fund consists of employer and employee contributions, plus earnings. CalPERS' investment portfolio is highly diversified between fixed income, real estate, and an increasing allocation to equities, both in the domestic and international markets. The domestic equity holdings are all indexed; the international stock is managed by outside managers, and is partially indexed.

Pension funds such as CalPERS are uniquely positioned in the market. For one thing, they are trust funds and must be prudently invested in accordance with standards of fiduciary duty. This results in a preference for the indexed management of stock, which is deemed prudent by most financial analysts.^[7]  For another, they are designed to pay benefits based on actuarial projections of retirement and mortality. These factors combine to shape a long-term investment horizon, one that is well-suited to the ownership perspective of a corporate governance campaign.^[8]

Several large public pension funds have long been involved in the corporate governance movement, along with CalPERS. The funds administered for employees of the states of Wisconsin, New York and Florida, and the city of New York, actively vote their proxies and have sponsored shareholder proposals. Now, private funds are joining the ranks.^[9]

Standards of Fiduciary Duty

The CalPERS Board members, along with System officers and employees, function as fiduciaries. As fiduciaries, they must discharge their responsibilities in accordance with the twin duties of loyalty and care. This is analogous to the duties owed by the directors of a corporation to its shareholders.

The duty of loyalty is sometimes referred to as the "sole purpose" doctrine. This means the Board and other CalPERS fiduciaries must act solely in the interest of members and beneficiaries. For this reason, CalPERS cannot base its corporate governance activities on social or political causes. Instead, it must focus on the "bottom line" of enhanced shareholder returns.

Under the duty of care, the Board and other CalPERS fiduciaries must manage fund assets as a "prudent investor." Essentially, this means with the care, skill and diligence that a prudent person, familiar with the matters, would exercise under similar circumstances in managing a pension fund of like size. Only the Board is authorized to invest the fund, although it may delegate this authority to other fiduciaries.

The duty of care safeguards the payment objectives of the fund, to ensure that the defined benefits can be paid when due at the time of retirement or death. The Board also has a duty to maximize the value of its investments, in order to avoid the increases in state and local government taxes that might otherwise be needed to pay the employer's share of costs.

Duty to Monitor

There is no distinct fiduciary duty to monitor investment performance, but CalPERS recognizes this duty as inherent in the concept of prudence.^[10] This is particularly true in regard to the performance of indexed stock, which follows the public market.

By the time a company's poor performance is publicly known, it is generally too late for an investor to take corrective action. Indeed, the underlying strategy of an index is to replicate the market. Under this strategy, if the market is in a downturn, then poor performers should not be sold. It is presumed that the marketplace is efficient, and that all stock will eventually be sold at the optimum trading price.

The history of indexing suggests special problems in monitoring. The U.S. Department of Labor (DOL), entrusted with oversight of the Employee Retirement Income and Security Act of 1974 (ERISA), has warned private pension fiduciaries that they may be held accountable for screening the performance of indexed holdings. An early DOL guideline, never rescinded, assumed that pension funds are screening their indexed holdings as an aspect of prudence.^[11]

01 of  05

¹ - "CalPERS has been and remains in the forefront of shareholder activists. It has often set the terms for debate and intervention in corporate matters. It is on the leading edge of . . . 'the glorious oversight revolution'." James P. Hawley and Andrew T. Williams with John U. Miller, Getting the Herd to Run: Shareholder Activism at the California Employees' Retirement System, Business and the Contemporary World (Fall 1994) at 11, 12.

² - Why Corporate Governance?" dated Nov. 11, 1989.

³ - This was a time of volatility in the stock market, caused by corporate raiders, leveraged buyouts and the accumulation of high debt.

⁴ - B. Graham and D. Dodd, Security Analysis, 1st Ed. (McGraw Hill, 1934) at p. 508. See also A. Berle and G. Means, The Modern Corporation and Private Property (PUB CO 1932), asserting that the American model of business had shifted from companies owned and managed by the same person, typically the founder, to corporations held by highly-fragmented groups of shareholders who had relinquished their control over management.

⁵ - See Gov. Code sec. 20100.

⁶ - See Calif. Const., Art. XVI, sec. 17.

⁷ - A recent survey shows that the average large pension fund in this country, both the defined benefit and defined contribution type, indexes about one-third of its total equity holdings. See Patterns of Institutional Investment and Control in the USA, The Brancato Report on Institutional Investment (May 1995), at Tables 9 & 10.

⁸ - Over the one-year period ending September 30, 1994, the weighted average for investment turnover by private and public pension funds was about half that of mutual funds, money managers and insurance companies. Id. at Table 1.

⁹ - For example, the pension fund managed by Campbell Soup Co. for its own employees has been widely reported as rallying other private funds to the movement. See Susan Pulliam, Campbell Soup Fund to Take Activist Role, The Wall St. J., July 15, 1993, at C1.

¹⁰ - Richard H. Koppes and Maureen L. Reilly, An Ounce of Prevention: Meeting the Fiduciary Duty to Monitor an Index Fund, forthcoming for publication in The J. of Corp. Law, Univ. of Iowa (Summer 1995).

¹¹ - See 29 C.F.R. sec. 2550.404a-1, DOL preamble to proposed regulations for the investment of plan assets, at fn. 7.

CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM
WHY CORPORATE GOVERNANCE TODAY?
A Policy Statement
August 14, 1995
Copyright Reserved

01 of  05